The Fed Inches Toward the ExitMichael Wallace
The Federal Open Market Committee—the policy-setting arm of the Federal Reserve—chose to stay the course heading into yearend. At the conclusion of its Dec. 15-16 policy meeting, the committee's time-tested "exceptionally low levels of the federal funds rate for an extended period" phrase survived another meeting intact. But in its post-meeting statement, the FOMC indicated that it will eventually wring out excess liquidity in the financial system starting in discrete stages next year. In fact, more details were provided about the Fed's natural escape plan for "special liquidity facilities" in a new final paragraph. The statement itself subtly upgraded the economic outlook, but retained the same patience on tolerable inflation risks given resource slack in the economy. There was only minor rebalancing of views on growth and inflation risks, and we got more detail in the statement about the timing of the expiration of the Fed's liquidity facilities next year. Policymakers not only repeated that economic activity has "continued to pick up," but noted that the deterioration in the labor market is "abating." The board also interjected that "financial market conditions have become more supportive of economic growth." The language on inflation risks, however, was left identical to the prior statement, and the vote was a unanimous 10-0. Economic OutlookThe Fed addressed the economic outlook thus: "Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit." Businesses, however, are still cutting back on fixed investment, though at a slower pace, the Fed noted, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Meanwhile, "[f]inancial market conditions have become more supportive of economic growth." Although the Fed indicated that it expects economic activity is likely to remain weak for a time, the FOMC "anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability." As for inflation: "With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time." Monetary PolicyThe paragraph from the Nov. 4 statement dealing with the Fed's policy and quantitative easing strategies, having grown ponderous, was more efficiently split into two pieces in the December communiqué. The committee said it will maintain the target range for the federal funds rate at 0 to 1/4 percent, and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, "are likely to warrant exceptionally low levels of the federal funds rate for an extended period." To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Fed maintained its plan to purchase $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The Fed said it is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. "The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets," policymakers wrote. Leading up to the decision, there had been speculation the FOMC might detail a formal separation of its monetary and liquidity policies, and in essence this came to pass with a new paragraph broken out to detail the finite timeline on several emergency facilities: "In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve's special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve's announcement of June 25, 2009." Among the alphabet soup of plans affected: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. Liquidity OperationsThe Fed also said it will be working with its central bank counterparties to close its temporary liquidity swap arrangements by Feb. 1. It added that it expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and Mar. 31, 2010, for loans backed by all other types of collateral. "The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth," the note added. This may have been included as a preliminary step toward unwinding accommodation in an attempt to mollify the committee's inflation hawks, given the still-accommodative policy stance. Indeed, the FOMC has allowed several of its liquidity operations to begin to run off, and has begun conducting reverse repo tests in preparation for further liquidity drains. There was even speculation that the Fed could nudge up the primary credit (discount) rate and discuss other policy tools, though no such changes were evident at this time. No changes were made to its asset purchase programs, with the Treasury buyback completed. Agency purchases are to be wound down in the first quarter with purchases of "about $175 billion," as before. Recovery's HeadwindsBut still-significant headwinds were noted until the recovery becomes self-sustaining. Despite the evident recovery in the housing and equity markets that have supported a real improvement in household wealth, liquidity and cash remain king into yearend, reflected in the steepening yield curve and sovereign credit angst. The Senate Finance Committee confirmation vote for Bernanke's second term is set for Dec. 17, though a full vote may be postponed a month. The Fed chief was since voted Time magazine's Person of the Year and despite public angst toward the Fed, confirmation will likely be a mere formality even as Bernanke continues to fight for Fed independence. Market reaction was fairly restrained on Dec. 16, as Treasury yields bounced moderately after the Fed statement largely hit all the expected policy buttons. The 2-year note had rebounded to 0.84% prior to the decision and held there, while the 10-year yield bounced 4 basis points toward 4-month highs of 3.62% again, compared with session lows of 3.54%. The dollar index initially dove lower, but rebounded above 77.0 as the Fed's escape plan crystallized a little. Equities wilted toward the close after an initial jag higher. While the Fed retained an exceptionally accommodative stance to support the economic recovery, and remained in no mood to prematurely stifle progress before the end of the year amid renewed global credit jitters, it has clearly laid out a path for change next year. Reductions in extremely low rates may still be some way off, but natural attrition of its emergency liquidity facilities will be the primary vehicle to begin to snug up monetary policy in 2010, assuming there continues to be no major growth relapse or exogenous event risk that interrupts those plans.